Real Return Team Viewpoint - October 2023

This is your last chance. After this, there is no turning back. You take the blue pill – the story ends, you wake up in your bed and believe whatever you want to believe. You take the red pill – you stay in Wonderland and I show you how deep the rabbit hole goes.

Morpheus, The Matrix (1999)

Introduction

In our July 2020 Real Return Team Viewpoint we argued that the world was collectively crossing the Rubicon. It quickly became clear that, after over a decade of using central bank-minted money to purchase securities, it would now be used to directly finance fiscal deficits, and on a large scale. Proponents of modern monetary theory had already been arguing for this approach prior to the pandemic, but in the blink of an eye, ideas that had remained confined to the fringes of policymaking circles went mainstream. From a macro perspective it was, to borrow from well-known investor Howard Marks, the most important thing.

The distribution of possible outcomes expanded massively. While the future is inherently unknowable, the probability that the recent past would serve as a prologue declined substantially. An understanding of what was to come required reaching back into the history books, and the decades retrospectively dubbed the “Great Moderation” were no longer your playbook.

Three and a half years on from the market lows, we continue to press into a new economic and market Wonderland. The rabbit hole runs deep and the bond market looks to be teetering on the edge of it.

Rock the Boat, Don’t Tip the Boat Over

This year, at the very end of the second quarter, US bond yields broke out from an extended consolidation that began with the peak in yields in October 2022. The impulsive move higher in yields has taken market participants by surprise, particularly given that the emergence of a disinflationary glide path had led to consensus settling on an economic ‘soft landing’ in the carefree days of July. August’s US consumer price index release showed an acceleration of inflation from the hitherto cycle low of 2.9% in June to 3.7% – enough to check those that thought the Federal Reserve had quelled inflation, but arguably not sufficient to warrant the recent rout in longer-dated bonds.

Contributing to the rout in the long-maturity US bonds was the fact that the US economy has remained remarkably resilient. Yet, in early July, the US 2s10s yield curve (a measure of the difference in interest rates between the two-year and 10-year Treasury bonds) was trading at over -1.1%, a whisker from the all-time low that followed the failure of Silicon Valley Bank in March. The bond market was betting on recession, but in reality, long rates appeared completely mispriced relative to the state of the US economy which has, so far, taken the accumulated rate hikes and a regional banking crisis in its stride.

A key reason why the US economy has boomed larger and longer than people expected is the magnitude of the government’s fiscal stimulus. With no loss of irony for those of us who attribute the inflationary experience of the last three years to fiscal largesse, the US administration has continued to juice the economy beyond Covid handouts. The Inflation Reduction Act and the CHIPS and Science Act have, among other schemes, kept the dollars flowing. The US is running a fiscal deficit north of 8% with record low unemployment.

Down the Rabbit Hole We Go

On August 2, the US Treasury announced the scale of the bond issuance needed to fund the deficit, and the bond market appeared to realize the enormity of what was coming, not just in the year ahead, but as far as the eye can see. With recession risk falling, cash rates above 5% and inflation still elevated, there was simply no reason to take duration risk. At the end of the quarter, following the abrupt repricing of the bond market, yields were trading at levels not seen since before the 2008 global financial crisis. The unexpected nature of the move and the belated realization that supply matters, particularly outside of recessions, have led to questions as to whether the bond market vigilantes are back in town.

A Disturbance in the Force

Needless to say, there will be debate about what caused the meltdown in government bonds. But the more immediate task is to figure out the consequences. Given government bonds – particularly US Treasuries – lie at the very heart of the global financial system, it would be naive to expect a crash of this magnitude not to have far-ranging repercussions. Government bonds are, of course, unique instruments in that many holders do not always need to mark to market; instead, they can sweep losses under the proverbial carpet and digest them over time. But when long-dated government bonds – proxied by the TLT iShares 20+ year US Treasury Bond ETF – had shed over 50% of their value from their July 31 high by quarter end, it is highly likely that the losses are imparting stress on parts of the financial system.

The last leg of the move higher in yields has been accompanied by a nascent but sharp widening of credit spreads (the excess yield offered versus government bonds). It is likely that the widening of spreads is a symptom of the speed of the move in yields rather than a sudden reassessment of the economic outlook and what this means for credit risk. Periods of systemic stress are characterized by rising correlations; it is not so much that the economic outlook has deteriorated, but rather a function of an endogenous force acting upon the unstable equilibrium that is the financial system. In 2008 it was US mortgage spreads, in 2011-12 European sovereign spreads, and in 2015 the renminbi exchange rate. Government bonds are of far greater significance to the global financial system than any of these prices. Interest rates and rate volatility are arguably the bedrock of the financial system, and we know that the cumulative interest-rate rises administered throughout the course of this hiking cycle are beginning to take a toll on the economic outlook. Rising stress within the financial system is now compounding the cyclical risks within the real economy.

No Such Thing as a Free Lunch

Arguably the most famous line in economics is that “there is no such thing as a free lunch”. The size and extent of US monetary and fiscal stimulus between March 2020 and late 2022 was not just a free lunch – it was a free banquet of epic proportions. It is very unlikely that such indulgence is not followed up with a hangover, and the same holds true for other economies that pursued large-scale monetary and fiscal stimulus. The US, however, partied way harder and way longer than anywhere else.

At some point parties always come to an end. The US economy has remained remarkably resilient, but the headwinds are mounting. Real interest rates are now at levels not seen sustainably since the 1990s. Banks are tightening credit, and there are growing signs of deteriorating credit quality. Furthermore, deficit spending is crowding out the private sector, while the fiscal impulse is set to turn negative in 2024.

Additionally, while the US may be the closest major economy that there is to an island, it is not immune to what happens elsewhere in the world. Booming growth in the US has come at the expense of growth elsewhere as financial capital flows into the US, tightening credit in the rest of the world. This is exacerbating China’s continuing internal problems and intensifying its economic malaise. Europe, too, is showing signs of economic weakness, particularly in the manufacturing sector and those economies leveraged to house prices. The saying goes that when the US sneezes, the world catches a cold; the same is likely to be true in reverse.

Crowding Out Returns

Higher yields are not only crowding out the real economy but also returns. For the first time in well over a decade, government bonds are offering a credible yield. The days of TINA (“there is no alternative” – when investors see stocks as the only viable option for investing their money) appear well and truly behind us. The current price volatility will no doubt keep some investors on the sidelines, but even if the longer-term trend in yields is higher, as we expect it is, there may be periods when government bonds have their time in the sun, particularly when the economy slows.

Less obviously, returns are likely to suffer given that higher interest rates set a higher bar for seeking earnings through financial engineering, and it is hard to overstate the prevalence of financial engineering in today’s corporate world, both in the private and public markets. To paraphrase the singer Rick James, leverage is a hell of drug. How the corporate world weans itself off cheap capital looks set to be a theme for the coming decade.